Why Your Cannabis Stocks Aren't Higher
Addressing the biggest elephant in the room, the United States government.
Quick Cannabis Legalization Recap
If you don’t already know, cannabis is not federally legal. Since 1970, federal law has classified cannabis as a Schedule I drug under the Controlled Substances Act.
Since 2012, 18 states and Washington, DC, have legalized marijuana for adults over the age of 21. And 37 states have legalized medical marijuana — meaning that a majority of Americans have access to cannabis, whether medically or recreationally.
Three states—New Mexico, Virginia, and South Dakota—passed legalization in recent months, and the laws took effect in late June and early July.
Canada legalized marijuana federally in 2018, but the U.S. has not followed suit, forcing states to chart their own courses.
Recently, however, Senator Chuck Schumer wanted to introduce a bill at the federal level to decriminalize cannabis. The Cannabis Administration and Opportunity Act would remove marijuana from the Controlled Substances Act and introduce regulations to tax cannabis products.
The proposal would expunge federal records of nonviolent cannabis offenders and allow people serving time in federal prison for nonviolent marijuana crimes to petition a court for resentencing.
Though this is an ambitious bill, Schumer has even said that he does not have the votes to make it law at this moment.
So what does all this regulation have to do with what’s causing your cannabis stocks? Let’s address it.
The Root of All Your Problems
Have you thought much about why many cannabis companies it seems have only gone down since their peaks back in 2018 despite recent good press with new a new government change?
I sure have. Even Tilray’s stock TLRY 0.00%↑ saw its stock climb to ~$150/share in 2018 and is now trading at ~$13.50. A stunning 90% drop.
I was there in 2018 working as an investment banker for Merrill Lynch covering the space. It was the next gold rush in everyone’s minds and numerous companies raced to go public, raise funds, utilize newfound cash to grow their reach and their high equity value to buy out/merge with other players.
My coverage spanned over 20 cannabis companies both in the U.S. and Canada.
It almost seemed as if everything was coming together and that the overall market would catch up with the speed that cannabis companies were moving. This proved to be not true with sky-high valuations coming back down to earth starting in late 2018.
This leaves me to tell you who is at the root of all your problems. The United States government.
Why the Government is Responsible
So the first thing I want to address is that it is not the government’s job nor prerogative to set the stage to appropriately value public companies. Their job is to regulate in what they think is the best interest of the American people. This often is a heated topic which is not what I’m getting at.
What I’m trying to highlight is how the government’s actions, or inactions, in this case, have indirectly led to suppressed cannabis valuations. There’s two major pain points that I see.
Because cannabis is not federally legal, that means that many large institutional investors and funds cannot or will not invest in publicly traded cannabis securities. It’s not their fault, it’s just the red tape that is figuratively handcuffing them from being able to do something about it.
So how does this tie into suppressed valuations you might ask? Well, let’s think high level just how institutional investors play a role in the markets.
Institutional investors are not you and me. We’re the little guy, aka, retail investors. They are the guys that run big funds like BlackRock, Fidelity, or numerous asset managers, mutual funds, etc. These guys handle hundreds of millions at the very least with upwards of hundreds of billions (BlackRock is the largest asset manager in the world with $9.5trillion, with a ‘t’) of assets under management.
This is a lot of capital that is not legally allowed to invest in many cannabis securities which means that less money is flowing into them.
This doesn’t necessarily mean that there’s little money in cannabis right now with various funds, just take a look below at some of the names that own Tilray stock.
With institutional ownership at ~12%, that means the bulk of shares are owned by special mutual funds (Calamos, above, is a market neutral fund) and retail investors.
However, if cannabis is legalized at the federal level, it could allow U.S. cannabis companies to up-list onto a major exchange (many trade over the counter (OTC) and gain full access to the capital markets. The move would also enable all institutional investors to get into cannabis stocks and service their clients/investors with exposure in the space.
This will allow billions of dollars from countless funds will pour into the markets. With more money flowing in, more active buyers will emerge pushing prices higher which means valuations will also be pushed higher.
Until this happens, cannabis securities will be dealing with retail investors (you and me), for the most part, which brings me to my next pain point.
No, I don’t mean how much cash they have in the bank. The liquidity that I mean describes the extent to which an asset can be bought and sold quickly, and at stable prices. In simple terms, it is a measure of how many buyers and sellers are present, and whether transactions can take place easily.
Market liquidity is important for several reasons, but primarily because it impacts how quickly you can open and close positions. A liquid market is generally associated with less risk, as there is usually always someone willing to take the other side of a given position. This can attract speculators and investors to the market, which adds to the favorable market conditions.
In a liquid market, a seller will quickly find a buyer without having to cut the price of the asset to make it attractive. And conversely, a buyer won’t have to pay an increased amount to secure the asset they want.
As we derive our prices from those in the underlying market, a lower bid-offer spread here will translate into lower spreads offered on the platform. If a market is illiquid, it could mean that there is a much wider spread.
So how does this tie in with cannabis? Well, it goes in part with what I mentioned above on how institutional money is not present within the publicly traded cannabis market.
Let me give an example with the chart below.
I chose five different companies and took a look at their average share price and daily volume over the last ten days, multiplied them together (avg. price * avg. shares) to get the daily average dollar value that was traded.
I chose companies in various industries to give you a feel for what I mean by a lack of liquidity.
Bank of America BAC 0.00%↑ - U.S. bank
Deere & Co. DE 0.00%↑ - U.S. farming equipment
Tilray TLRY 0.00%↑ - Canadian cannabis multi-state operator which trades on a major U.S. exchange
Agrify AGFY 0.00%↑ - U.S. vertical farming company that caters mainly to cannabis companies (does not physically touch cannabis)
Green Thumb Industries (GTBIF) - One of the largest U.S. cannabis multi-state operators by market cap (~$6.1bn) that trades over the counter (OTC)
I also want you to understand that share volume does not equate to liquidity. If a stock is $3 a share and trades 1mm shares a day, that’s only $3mm traded daily. However, if a company trades 300k shares a day but its price is $100 a share, that’s $30mm traded daily. More money flowing in and out from buyers and sellers. See what I mean?
So with that being said and applying it to the above select companies, you can see that Bank of America and Deere have no real issues with liquidity. They're both major names and have no restrictions to them as far as regulation for ownership.
However, once you start getting more cannabis-focused, the numbers start to decline. Tilray trades on a major U.S. exchange and is Canadian based, therefore, more market demand because they don't fall under the same rules as American players. When you get to Agrify, though it does not touch cannabis, it has a market cap of ~$600mm and is 7x more liquid than Green Thumb Industries who has a market cap of ~$6.1bn.
This low level of liquidity might make sense for the little retail investor, but for an institutional investor managing $1bn or more, it’s just not feasible. For them to take a position in these illiquid cannabis companies, they might run the risk of driving up the price or have to potentially expand their losses should they need to sell quickly.
And that my friends is why big money also refrains from taking a position in these names which consequently has an effect on price movements.
Tying the Both Together
Without diving into the operations portion on why cannabis company prices/valuations are also suppressed (leaving that for a later, more in-depth article), these two points sum it up at a high level.
With institutional money sitting on the sidelines, less money is flowing in and out of these companies on a daily basis causing not much price movement towards the upside.
This makes it even more necessary to understand position sizing when buying into them so that you don't end up on the rig side of a trade.
Until regulation changes so that institutional money can start buying into these companies, I predict that we'll continue to see very volatile price movements in the years to come.
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